Why Did the White House Tap the SPR?

Ed Wallace

July 1, 2011, 3:10 PM EDT

The media pounced on the announcement on June 23 that the Obama Administration, in conjunction with the International Energy Agency, had decided to release 60 million barrels of crude from strategic petroleum reserves worldwide. Here was the official proof that something tangible was being done to alleviate the "worldwide oil shortages, caused"—as was published numerous times—by the loss of Libyan oil production in the country’s ongoing civil war.

By Thursday night and continuing into Friday, TV stations across the U.S. were discussing how, around the world, this announcement was already dramatically lowering the price of crude.

In the excitement of a big energy story like this, maybe the media can be forgiven for having let oil-related news they’d gotten the week before completely slip their minds.

Just six days earlier Bloomberg had quoted the American Petroleum Institute as saying "U.S. oil supplies rose to the highest level in 31 years for the month of May, as refineries processed less crude amid a decline in gasoline demand." The API’s website was even more explicit: "Gasoline deliveries were down from May a year ago and down year-to-date from 2010. At 9.2 million barrels per day, they slipped to an eight-year low for May, not including May 2009."

So why did the White House release the oil?

THERE IS NO OIL SHORTAGE, PART VII

It wasn’t because of lack of supply. The Energy Information Administration’s own website showed that oil on hand during the last week of May was a more than healthy 373.8 million barrels; according to the government’s data you’d have to go back to the summer of 1990 to find crude inventories that high. To make a direct comparison, in January of 1999, when gasoline was selling for $1 a gallon and oil had dropped almost to $10 a barrel, U.S. inventories of crude started the year at 321 million barrels.

But it’s not just America’s oil inventories that matter. So it’s worth noting that the day before the oil release announcement, Platt’s published an article on China’s energy demands; it did show that the country’s overall demand for oil was increasing—but, “Coupled with increased production, the fall in consumption helped to boost inventories, and oil product stocks at the end of last month were 1 million mt [metric tonnes] more than a year ago." So, while U.S. inventories of crude are at near record highs, China’s inventories have also risen, although not nearly as much.

As for Europe, it was only two months ago that Exxon Chief Executive Rex Tillerson told the Financial Times that inventories in the U.S. were at "near-record highs" and stocks in Europe and Asia were within the normal ranges. "So there’s plenty of oil on the market."

DEMAND DYING EVERYWHERE

After the announcement the media were quick to say that releasing this oil from strategic petroleum reserves had cut the price of crude by $4 a barrel. Where did they start counting? At 5:00 A.M. CST the morning of the announcement, Bloomberg’s Commodities page showed West Texas Intermediate crude selling for $93.08; and at five the next morning it was $91.71, a net decrease of just $1.37 a barrel.

More important, however, was the news that the oil to be released from the U.S. SPR would have a strike price of $112.79 a barrel, based on the previous five days’ sales of Louisiana Light Sweet Crude. This is a preferred top-grade refining crude, as all light sweet blends are; but the only way the released SPR oil could truly lower market pricing is by increasing the amount of oil preferred by most refiners, thereby taking some pressure off the need for other crudes.

What’s probably even more responsible for taking the pressure off all oil is the falloff in U.S. gasoline demand. In fact, the price of oil had already slid 16 percent in the two weeks prior to this joint IEA-U.S. announcement, and for that very reason. In the excitement of that day, everyone ignored the Federal Highway Administration’s study, which showed that the number of miles driven by U.S. motorists had fallen 2.4 percent in the previous month, for 6.1 billion fewer miles driven.

That could also explain why gasoline prices on the futures market had been falling since early May.

"STREET"-WISE PERFORMANCE

Some in the media suggested that this announcement was directly aimed at speculators, which Commodities Futures Trading Commission head Gary Gensler recently stated now control 88 percent of all contracts in WTI crude. That would leave legitimate buyers for crude holding only 12 percent of the outstanding contracts. But if that were true, one would think the Administration could have set a strike price for some of our nation’s finest oil at far less than the $112.79 market value, just to ensure that those speculators reconsidered their holdings in oil.

Therein lies the problem. It’s true that Exxon’s Tillerson told Congress on May 12 that based on supply and demand, oil should be selling in the range of $60 to $70 a barrel. But if the government actually took concrete actions to force the price of crude down to the legitimate discovery price, what would be the impact on our financial system?

After all, we allow leveraging of up to 30:1 for speculators to buy commodity contracts, and that’s one of the key reasons why oil prices are far beyond their discovery price. But it’s also a minefield for speculators; what if suddenly they found those contracts they held were worth only 65 percent of their face value? Losses on the borrowed money would fast run into the tens of billions of dollars. It’s hard to cover that type of margin call, not to mention the panic it would put back into the financial system.

So far it’s being reported that the release announcement’s only impact on the market has been the bad bets placed on the spread between heavy sour Dubai crude and Brent. For what it’s worth, after just six days, West Texas Intermediate was higher than it was before the IEA’s announcement. Oh, and gasoline futures, in spite of declining demand, have shot back up to $3 a gallon.

SPECULATORS CONTROL 88 PERCENT OF WTI TRADES

All the excitement over the SPR release seems to be much ado about nothing. Because it is possible—though it might have been only a temporary situation—that oil was already starting a near-term decline to more reasonable and accurate pricing, whether oil had been released from strategic petroleum reserves or not. The fact is that the net price of crude on futures markets had already fallen 11 percent in the second quarter.

It’s time to state how the futures market for crude should really be looked at. There is no real demand for oil for oil’s sake in the world. What there is, is a demand for refined fuels.

What we have seen over and over again, certainly this year and in 2008, is that speculators consider oil the product to chase. This forces refiners to ensure their profitability by finding ways to deliver less of their refined products to the market. This is one reason, possibly a key reason, why we are witnessing refining utilizations this year far below what is considered normal. If our refineries were running full out, we would see a major and uncontrollable glut in everything from gasoline to heating oil to aviation fuel—resulting in those products’ falling prices on the futures market, which would guarantee a loss for refiners.

In the real world, it should be the demand, supply, and bid price for fuels that determine what refiners are willing to pay for oil, not the other way around. And that statement alone makes clear how speculators, controlling 88 percent of contracts on WTI crude (and possibly similar percentages of other crudes worldwide), have distorted oil’s price structure to the detriment of our economy.

Just remember that, even as the media continued to report that there were oil shortages worldwide—which even the heads of major oil companies denied—the API reported that demand for gasoline slipped to an 8-year low in May.

Oil was already falling because demand for refined fuels had weakened. And if the media focused on that issue, it’s likely oil prices would fall even farther.

To continue reading this article you must be a Bloomberg Professional Service Subscriber.